
[Federal Register Volume 78, Number 71 (Friday, April 12, 2013)]
[Notices]
[Pages 22001-22004]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 2013-08612]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-69344; File No. SR-Phlx-2013-29]


Self-Regulatory Organizations; NASDAQ OMX PHLX LLC; Order 
Granting Accelerated Approval of a Proposed Rule Change To Address 
Obvious and Catastrophic Options Errors in Response to the Regulation 
NMS Plan To Address Extraordinary Market Volatility

April 8, 2013.

I. Introduction

    On March 14, 2013, NASDAQ OMX PHLX LLC (``Phlx'' or ``Exchange'') 
filed with the Securities and Exchange Commission (``Commission''), 
pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 
(the ``Act'') \1\ and Rule 19b-4 thereunder,\2\ a proposed rule change 
to provide for how the Exchange proposes to treat obvious and 
catastrophic options errors in response to the Regulation NMS Plan to 
Address Extraordinary Market Volatility (the ``Plan''). The proposed 
rule change was published for comment in the Federal Register on March 
20, 2013.\3\ The Commission received one comment letter on the 
proposal.\4\ This order approves the proposed rule change on an 
accelerated basis.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ Securities Exchange Act Release No. 69141 (March 15, 2013), 
78 FR 17262 (``Notice'').
    \4\ See Letter to Heather Seidel, Associate Director, Division 
of Trading and Markets, Commission, from Thomas A. Wittman, 
President, Phlx, dated April 5, 2013 (``Phlx Letter'').
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II. Description of the Proposed Rule Change

    Since May 6, 2010, when the financial markets experienced a severe 
disruption, the equities exchanges and the Financial Industry 
Regulatory Authority have developed market-wide measures to help 
prevent a recurrence. In particular, on May 31, 2012, the Commission 
approved the Plan, as amended, on a one-year pilot basis.\5\ The Plan 
is designed to prevent trades in individual NMS stocks from occurring 
outside of specified Price Bands, creating a market-wide limit up-limit 
down mechanism that is intended to address extraordinary market 
volatility in NMS Stocks.\6\
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    \5\ Securities Exchange Act Release No. 67091 (May 31, 2012), 77 
FR 33498.
    \6\ Unless otherwise specified, capitalized terms used in this 
rule filing are based on the defined terms of the Plan.
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    In connection with the implementation of the Plan, the Exchange 
proposes to adopt new Rule 1047(f)(v) to exclude electronic trades that 
occur during a Limit State or Straddle State from the obvious error or 
catastrophic error review procedures pursuant to Rule 1092(a)(i) or 
(ii) and the nullification or adjustment provisions pursuant to Rule 
1092(c)(ii)(E) or (F), for a one year pilot basis from the date of 
adoption of the proposed rule change.\7\ The Exchange proposes to 
retain the ability to review electronic trades that occur during a 
Limit State or Straddle State by Exchange motion pursuant to Rule 
1092(e)(i)(B).
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    \7\ The Exchange stated that various members of the Exchange 
staff have spoken to a number of member organizations about obvious 
and catastrophic errors during a Limit State or Straddle State and 
that a variety of viewpoints emerged, mostly focused on having many 
trades stand, on fairness and fair and orderly markets, and on being 
able to re-address the details during the course of the pilot, if 
needed.
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    Under Rule 1092(a)(i) and (ii), obvious and catastrophic errors are 
calculated by determining a theoretical price and applying such price 
to ascertain whether the trade should be nullified or adjusted. 
Pursuant to Rule 1092(a)(i) and (ii), obvious and catastrophic errors 
are determined by comparing the theoretical price of the option, 
calculated by one of the methods in Rule 1092(b), to an adjustment 
table in Rule 1092(a). Generally, the theoretical price of an

[[Page 22002]]

option is the National Best Bid and Offer (``NBBO'') of the option. In 
certain circumstances, Exchange officials have the discretion to 
determine the theoretical price.\8\
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    \8\ Specifically, under Rule 1092(b), the theoretical price is 
determined in one of three ways: (i) If the series is traded on at 
least one other options exchange, the last National Best Bid price 
with respect to an erroneous sell transaction and the last National 
Best Offer price with respect to an erroneous buy transaction, just 
prior to the trade; (ii) as determined by an Options Exchange 
Official in its discretion, if there are no quotes for comparison 
purposes, or if the bid/ask differential of the NBBO for the 
affected series, just prior to the erroneous transaction, was at 
least two times the permitted bid/ask differential under the 
Exchange's rules; or (iii) for transactions occurring as part of the 
Exchange's automated opening system, the theoretical price shall be 
the first quote after the transaction(s) in question that does not 
reflect the erroneous transaction(s).
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    The Exchange believes that none of these methods is appropriate 
during a Limit State or Straddle State. Under Rule 1092(b)(i), the 
theoretical price is determined with respect to the NBBO for an option 
series just prior to the trade. According to the Exchange, during a 
Limit State or Straddle State, options prices may deviate substantially 
from those available prior to or following the state. The Exchange 
believes this provision would give rise to much uncertainty for market 
participants as there is no bright line definition of what the 
theoretical price should be for an option when the underlying NMS stock 
has an unexecutable bid or offer or both. Because the approach under 
Rule 1092(b)(i) by definition depends on a reliable NBBO, the Exchange 
does not believe that approach is appropriate during a Limit State or 
Straddle State. Additionally, because the Exchange system will only 
trade through the theoretical bid or offer if the Exchange or the 
participant (via an ISO order) has accessed all better priced interest 
away in accordance with the Options Order Protection and Locked/Crossed 
Markets Plan, the Exchange believes potential trade reviews of 
executions that occurred at the participant's limit price and also in 
compliance with the aforementioned Plan could harm liquidity and also 
create an advantage to either side of an execution depending on the 
future movement of the underlying stock.
    With respect to Rule 1092(b)(ii) affording discretion to the 
Options Exchange Official to determine the theoretical price and 
thereby, ultimately, whether a trade is busted or adjusted and to what 
price, the Exchange notes that it would be difficult to exercise such 
discretion in periods of extraordinary market volatility and, in 
particular, when the price of the underlying security is unreliable. 
The Exchange again notes that the theoretical price in this context 
would be subjective.\9\ Ultimately, the Exchange believes that adding 
certainty to the execution of orders in these situations should 
encourage market participants to continue to provide liquidity to the 
Exchange, thus promoting fair and orderly markets. On balance, the 
Exchange believes that removing the potential inequity of nullifying or 
adjusting executions occurring during Limit States or Straddle States 
outweighs any potential benefits from applying these provisions during 
such unusual market conditions.
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    \9\ The Exchange also notes that the determination of 
theoretical price under Rule 1092(b)(iii) applies to trades executed 
during openings. Because the Exchange does not intend to open an 
option during a Limit State or Straddle State, this provision will 
not apply.
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    Additionally, the Exchange proposes to provide that trades would 
not be subject to review under Rule 1092(c)(ii)(E) during a Limit or 
Straddle State. Under Rule 1092(c)(ii)(E), a trade may be nullified or 
adjusted where an execution occurred in a series quoted no bid. The 
Exchange believes that these situations are not appropriate for an 
error review because they are more likely to result in a windfall to 
one party at the expense of another in a Limit State or Straddle State, 
because the criteria for meeting the no-bid provision are more likely 
to be met in a Limit State or Straddle State, and unlike normal 
circumstances, may not be a true reflection of the value of the series 
being quoted.
    In response to these concerns, the Exchange proposes to adopt Rule 
1047(f)(v) to provide that electronic trades are not subject to an 
obvious error or catastrophic error review pursuant to Rule 1092(a)(i) 
and (ii) and Rule 1092(c)(ii)(F) during a Limit State or Straddle 
State. In addition, the Exchange proposes to provide that electronic 
trades are not subject to review if, pursuant to Rule 1092(c)(ii)(E), 
the trade resulted in an execution in a series quoted no bid.
    Finally, proposed Rule 1047(f)(v) also will include a qualification 
that nothing in proposed Rule 1047(f)(v) will prevent electronic trades 
from being reviewed on Exchange motion pursuant to Rule 1092(e)(i)(B). 
According to the Exchange, this safeguard will provide the flexibility 
to act when necessary and appropriate, while also providing market 
participants with certainty that trades they effect with quotes and/or 
orders having limit prices will stand irrespective of subsequent moves 
in the underlying security. The right to review on Exchange motion 
electronic transactions that occur during a Limit State or Straddle 
State under this provision, according to the Exchange, would enable the 
Exchange to account for unforeseen circumstances that result in obvious 
or catastrophic errors for which a nullification or adjustment may be 
necessary in order to preserve the interest of maintaining a fair and 
orderly market and for the protection of investors.

III. Discussion

    The Commission finds that the Exchange's proposed rule change is 
consistent with the requirements of the Act and the rules and 
regulations thereunder applicable to a national securities 
exchange.\10\ Specifically, the Commission finds that the proposal is 
consistent with Section 6(b)(5) of the Act,\11\ in that it is designed 
to prevent fraudulent and manipulative acts and practices, promote just 
and equitable principles of trade, foster cooperation and coordination 
with persons engaged in regulating, clearing, settling, processing 
information with respect to, and facilitating transactions in 
securities, remove impediments to and perfect the mechanism of a free 
and open market and a national market system, and, in general, protect 
investors and the public interest.
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    \10\ In approving this proposed rule change, the Commission has 
considered the proposed rule's impact on efficiency, competition, 
and capital formation. See 15 U.S.C. 78c(f).
    \11\ 15 U.S.C. 78f(b)(5).
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    In the filing, the Exchange notes its belief that suspending 
certain aspects of Rule 1092 during a Limit State or Straddle State 
will ensure that limit orders that are filled during a Limit or 
Straddle State will have certainty of execution in a manner that 
promotes just and equitable principles of trade and removes impediments 
to, and perfects the mechanism of, a free and open market and a 
national market system. The Exchange believes the application of the 
current rule would be impracticable given what it perceives will be the 
lack of a reliable NBBO in the options market during Limit States and 
Straddle States, and that the resulting actions (i.e., nullified trades 
or adjusted prices) may not be appropriate given market conditions. In 
addition, given the Exchange's view that options prices during Limit 
States or Straddle States may deviate substantially from those 
available shortly following the Limit State or Straddle State, the 
Exchange believes that providing market participants time to re-
evaluate a transaction executed during a Limit or

[[Page 22003]]

Straddle State will create an unreasonable adverse selection 
opportunity that will discourage participants from providing liquidity 
during Limit States or Straddle States. Ultimately, the Exchange 
believes that adding certainty to the execution of orders in these 
situations should encourage market participants to continue to provide 
liquidity to the Exchange during Limit States and Straddle States, thus 
promoting fair and orderly markets.
    The Exchange, however, has proposed this rule change based on its 
expectations about the quality of the options market during Limit 
States and Straddle States. The Exchange states, for example, that it 
believes that application of the obvious and catastrophic error rules 
would be impracticable given the potential for lack of a reliable NBBO 
in the options market during Limit States and Straddle States. Given 
the Exchange's recognition of the potential for unreliable NBBOs in the 
options markets during Limit States and Straddle States, the Commission 
is concerned about the extent to which investors may rely to their 
detriment on the quality of quotations and price discovery in the 
options markets during these periods. This concern is heightened by the 
Exchange's proposal to exclude electronic trades that occur during a 
Limit State or Straddle State from the obvious error or catastrophic 
error review procedures pursuant to Rule 1092(a)(i) or (ii) and the 
nullification or adjustment provisions pursuant to Rule 1092(c)(ii)(E) 
or (F). The Commission urges investors and market professionals to 
exercise caution when considering trading options under these 
circumstances. Broker-dealers also should be mindful of their 
obligations to customers that may or may not be aware of specific 
options market conditions or the underlying stock market conditions 
when placing their orders.
    While the Commission remains concerned about the quality of the 
options market during the Limit and Straddle States, and the potential 
impact on investors of executing in this market without the protections 
of the obvious or catastrophic error rules that are being suspended 
during the Limit and Straddle States, it believes that certain aspects 
of the proposal could help mitigate those concerns.
    First, despite the removal of obvious and catastrophic error 
protection during Limit States and Straddle States, the Exchange states 
that there are additional measures in place designed to protect 
investors. For example, the Exchange states that by rejecting market 
orders and stop orders, and cancelling pending market orders and stop 
orders, only those orders with a limit price will be executed during a 
Limit State or Straddle State. Additionally, the Exchange notes the 
existence of SEC Rule 15c3-5 requiring broker-dealers to have controls 
and procedures in place that are reasonably designed to prevent the 
entry of erroneous orders. Finally, with respect to limit orders that 
will be executable during Limit States and Straddle States, the 
Exchange states that it applies price checks to limit orders that are 
priced sufficiently far through the NBBO. Therefore, on balance, the 
Exchange believes that removing the potential inequity of nullifying or 
adjusting executions occurring during Limit States or Straddle States 
outweighs any potential benefits from applying certain provisions 
during such unusual market conditions.
    The Exchange also believes that the aspect of proposed rule change 
that will continue to allow the Exchange to review on its own motion 
electronic trades that occur during a Limit State or a Straddle State 
is consistent with the Act because it would provide flexibility for the 
Exchange to act when necessary and appropriate to nullify or adjust a 
transaction and will enable the Exchange to account for unforeseen 
circumstances that result in obvious or catastrophic errors for which a 
nullification or adjustment may be necessary in order to preserve the 
interest of maintaining a fair and orderly market and for the 
protection of investors. The Exchange represents that it recognizes 
that this provision is limited and that it will administer the 
provision in a manner that is consistent with the principles of the 
Act. In addition, the Exchange represents that it will create and 
maintain records relating to the use of the authority to act on its own 
motion during a Limit State or Straddle State.
    Finally, the Exchange has proposed that the changes be implemented 
on a one year pilot basis. The Commission believes that it is important 
to implement the proposal as a pilot. The one year pilot period will 
allow the Exchange time to assess the impact of the Plan on the options 
marketplace and allow the Commission to further evaluate the effect of 
the proposal prior to any proposal or determination to make the changes 
permanent. To this end, the Exchange has committed to: (1) Evaluate the 
options market quality during Limit States and Straddle States; (2) 
assess the character of incoming order flow and transactions during 
Limit States and Straddle States; and (3) review any complaints from 
members and their customers concerning executions during Limit States 
and Straddle States. Additionally, the Exchange has agreed to provide 
the Commission with data requested to evaluate the impact of the 
elimination of the obvious error rule, including data relevant to 
assessing the various analyses noted above. On April 5, 2013, the 
Exchange submitted a letter stating that it would provide specific data 
to the Commission and the public and certain analysis to the Commission 
to evaluate the impact of Limit States and Straddle States on liquidity 
and market quality in the options markets.\12\ This will allow the 
Commission, the Exchange, and other interested parties to evaluate the 
quality of the options markets during Limit States and Straddle States 
and to assess whether the additional protections noted by the Exchange 
are sufficient safeguards against the submission of erroneous trades, 
and whether the Exchange's proposal appropriately balances the 
protection afforded to an erroneous order sender against the potential 
hazards associated with providing

[[Page 22004]]

market participants additional time to review trades submitted during a 
Limit State or Straddle State.
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    \12\ In particular, the Exchange represented that, at least two 
months prior to the end of the one year pilot period of proposed 
Section 3(d)(iv), it would provide to the Commission an evaluation 
of (i) the statistical and economic impact of Straddle States on 
liquidity and market quality in the options market and (ii) whether 
the lack of obvious error rules in effect during the Limit States 
and Straddle States are problematic. In addition, the Exchange 
represented that each month following the adoption of the proposed 
rule change it would provide to the Commission and the public a 
dataset containing certain data elements for each Limit State and 
Straddle State in optionable stocks. The Exchange stated that the 
options included in the dataset will be those that meet the 
following conditions: (i) The options are more than 20% in the money 
(strike price remains greater than 80% of the last stock trade price 
for calls and strike price remains greater than 120% of the last 
stock trade price for puts when the Limit State or Straddle State is 
reached); (ii) the option has at least two trades during the Limit 
State or Straddle State; and (iii) the top ten options (as ranked by 
overall contract volume on that day) meeting the conditions listed 
above. For each of those options affected, each dataset will 
include, among other information: Stock symbol, option symbol, time 
at the start of the Limit State or Straddle State and an indicator 
for whether it is a Limit State or Straddle State. For activity on 
the Exchange in the relevant options, the Exchange has agreed to 
provide executed volume, time-weighted quoted bid-ask spread, time-
weighted average quoted depth at the bid, time-weighted average 
quoted depth at the offer, high execution price, low execution 
price, number of trades for which a request for review for error was 
received during Limit States and Straddle States, an indicator 
variable for whether those options outlined above have a price 
change exceeding 30% during the underlying stock's Limit State or 
Straddle State compared to the last available option price as 
reported by OPRA before the start of the Limit or Straddle State (1 
if observe 30% and 0 otherwise), and another indicator variable for 
whether the option price within five minutes of the underlying stock 
leaving the Limit State or Straddle State (or halt if applicable) is 
30% away from the price before the start of the Limit State or 
Straddle State. See Phlx Letter, supra note 4.
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    Finally, the Commission notes that the Plan, to which these rules 
relate, will be implemented on April 8, 2013. Accordingly, for the 
reasons stated above, and in consideration of the April 8, 2013 
implementation date of the Plan, the Commission finds good cause, 
pursuant to Section 19(b)(2) of the Act,\13\ for approving the 
Exchange's proposal prior to the 30th day after the publication of the 
notice in the Federal Register.
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    \13\ 15 U.S.C. 78s(b)(2). The Commission noticed substantially 
similar rules proposed by NYSE MKT LLC and NYSE Arca, Inc. with a 
full 21 day comment period. See Securities Exchange Act Release No. 
69033, 78 FR 15067 (March 8, 2013) and Securities Exchange Act 
Release No. 69032, 78 FR 15080 (March 8, 2013).
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IV. Conclusion

    It is therefore ordered, pursuant to Section 19(b)(2) of the 
Act,\14\ that the proposed rule change (SR-Phlx-2013-29), be, and 
hereby is, approved on an accelerated basis.
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    \14\ 15 U.S.C. 78s(b)(2).

    For the Commission, by the Division of Trading and Markets, 
pursuant to delegated authority.\15\
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    \15\ 17 CFR 200.30-3(a)(12).
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Kevin M. O'Neill,
Deputy Secretary.
[FR Doc. 2013-08612 Filed 4-11-13; 8:45 am]
BILLING CODE 8011-01-P


